Pips are what everyone is after in Forex trading; as many pips as possible, to be precise.
The Forex market as we know it today has evolved over time. A decade ago, trading conditions offered by brokers were very different from current ones. The recent technological advances allow brokers to offer more accurate trade executions and quotations of currency pairs. While a few years ago a quote had four digits, now most currency pairs have five-digit quotations.
Let’s consider the EUR/USD pair; the most popular and liquid currency pair of Forex. Any currency pair comes with two prices: the Bid and Ask price. At the time this was written the EUR/USD had a Bid price of 1.17603. If the investor has a bearish sentiment for the EUR/USD pair and wants to trade it short, they will sell directly from the Bid price, or at 1.17603 (a five-digit quote reflecting the accuracy of the price quotation from the broker). If the price moves lower, say to 1.17305 at the Ask price, the difference represents the potential gain. This difference is calculated in pips, and the pip refers to the fourth digit. Therefore, in this case, the potential gain would be the difference between the entry and exit price. Or, 29.8 pips and NOT 298 pips.
The Value of a Pip
It isn’t uncommon for investors to refer to the success or failure of a trade with the number of pips gained or lost. However, the value of a pip can differ based on many factors.
One factor is the volume traded. The volume, or the number of lots/micro-lots traded, determines the value of each pip. There is a direct correlation here; the larger the volume, the bigger the potential reward. But also, the potential risk.
The value of a pip is a vital component of any money management strategy. Investors use money management rules to cope with volatility in the FX markets and to have increased chances of success when trading. Therefore, it is not about the number of pips made in a trade. Instead, it is about the value of those pips, which is related to the trading account size.
The pip also defines the spread between the Bid and Ask prices. The spread differs from currency pair to currency pair, with the most liquid currencies having a tight spread, and the less liquid currencies a wider one.
The number of pips central to money management strategies because it defines the risk and the reward of a trade. Obviously, if the reward outweighs the risk, this is better for the trading account and for the overall strategy.
- A pip is the fourth digit in the quote of a currency pair.
- It defines both the risk and the reward of a trade or trading strategy.
- The value of a pip is distinct from the number of pips an investor makes.
- Pips are a crucial component of any money management system as they define risk-reward ratios and overall market approach.